Legal Opinions Addressing Uncertain Tax Positions May Be Desirable under New FASB Rules

New guidance issued by the Financial Accounting Standards Board (FASB) makes significant changes in the way a company must recognize, measure and disclose uncertain income tax positions in its financial statements. The guidance, which is effective for fiscal years beginning after December 15, 2006, was issued as Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Tax: An Interpretation of FASB Statement No. 109.

FIN 48 mandates that companies evaluate all material income tax positions for periods that remain open under applicable statutes of limitation as well as positions expected to be taken in future returns. This will be a massive undertaking for a company's in-house staff. In some instances, a company may want to involve outside counsel in the process. Although FIN 48 does not require a company to obtain a tax opinion from outside counsel, such an opinion can be external evidence supporting the company's position and may be helpful in discussions with the company's outside auditors.

The "More Likely Than Not" Standard for Recognition

Under FIN 48, a company can recognize an income tax benefit only if the position has a "more likely than not" (i.e., more than 50 percent) chance of being sustained on the technical merits. In making this determination, the possibility that the company will not be audited, or that the position will escape an auditor's notice, cannot be taken into account. The adoption of the "more likely than not" standard is a welcome development. FASB had previously been considering allowing the booking of tax benefits only if they were "probable," an ambiguous term that some had read as meaning something in the neighborhood of 75 percent.

In analyzing whether a position has a "more likely than not" chance of success, management must consider a wide range of factors, including statutes, cases, regulations and rulings. Fortunately, FIN 48 allows the consideration of administrative practices as well. There may be situations in which a position might be technically contrary to statutory law, yet the tax authorities may allow it. FIN 48 cites the example of a $2,000 capitalization threshold. If management concludes from prior audits, its knowledge of audits of similar companies, and from discussions with external tax advisors that the taxing authorities will allow the threshold, then the tax benefits may be recognized.

Knowledge of administrative practice might also be helpful where a company has not filed income tax returns in a state, yet the company cannot technically support (at a "more likely than not" level) the conclusion that it does not have nexus. If no return is filed, the statute of limitations typically does not run, which creates the possibility of an ever-growing book liability that would never reverse. However, if the state taxing authorities had a well-known practice of assessing back taxes for a limited number of years, then FIN 48 allows a company to take that into account.

If a tax position does not meet the "more likely than not" recognition threshold in the first tax period, the benefits cannot be booked. However, they may be booked later if: (1) the threshold is met in a later period; (2) the matter is resolved; or (3) the statute of limitations expires. FIN 48 calls for derecognition of a previously recognized position in the first tax period in which it is no longer more likely than not that the position would be sustained on its technical merits.

Measurement Requires a "Cumulative Probability" Analysis

If a position has a "more likely than not" chance of being sustained on the technical merits, then as a second step the company must measure the benefit using a "cumulative probability" analysis. FIN 48 observes that most uncertain tax positions are resolved through negotiation rather than litigation, and it therefore requires the measurement to be based on management's best judgment about the amount the taxpayer would accept to settle the issue.

A company should recognize the largest amount of benefit that is greater than 50 percent likely of being realized in settlement. The following example illustrates this analysis:

Because the cumulative probability at the $60 level exceeds 50% (i.e., 10% plus 25% plus 25% equals 60%), the company is permitted to book a $60 tax benefit.

This measurement process, which requires an evaluation of settlement probability at multiple levels, seems quite cumbersome and speculative. In our experience, taxpayers do not try to evaluate the odds at various levels of possible result. They more commonly evaluate the overall odds of winning or losing. It remains to be seen how this process will work in practice.

What About the IRS?

Disclosure of uncertain tax positions can be problematic if doing so provides a road map to the taxing authorities of what the difficult issues may be. In general, FIN 48 does not require disclosure of the specific issues. However, for positions in which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months, FIN 48 requires disclosure of the nature of the uncertainty, the nature of the event that could occur within 12 months to cause a change, and an estimate of the range of change or a statement that an estimate cannot be made.

Of course, the Internal Revenue Service may request the production of tax-accrual workpapers. Historically, the IRS has exercised restraint in making such requests, but in 2002 it announced a new policy under which it will request tax accrual workpapers related to a taxpayer's participation in a listed transaction if the taxpayer engaged in a single listed transaction, even if that transaction was properly disclosed. Moreover, the IRS generally will request all tax accrual workpapers if the taxpayer engaged in multiple listed transactions or in a single listed transaction that was not properly disclosed.

Tax Opinions as External Evidence Supporting Management

FIN 48 does not require that a company obtain a legal opinion in order to recognize a tax benefit, but some companies may want to engage an outside law firm to provide one. According to FIN 48, a tax opinion "can be external evidence supporting a management assertion and that management should decide whether to obtain a tax opinion after evaluating the weight of all available evidence and the uncertainties of the applicability of the relevant statutory or case law."

In other words, if a tax position is material, and if the position is uncertain enough that the company's auditors may question it, the company may find it useful to engage a law firm for the purpose of drafting an opinion and discussing the issue with the company's auditors. Even before FIN 48, Faegre & Benson lawyers were engaged to perform similar services. FIN 48, with its requirement that a tax position be more likely than not to be recognized, would seem to increase the desirability of involving legal counsel.

One question that has been of concern to taxpayers is whether legal advice will be privileged if it is disclosed to a company's auditors. That question has been a particularly hot one since the IRS abandoned its traditional policy of acting with restraint in requesting tax-accrual workpapers. The IRS contends that neither the attorney-client privilege, the work-product privilege, nor the I.R.C. § 7525 privilege applies to tax-accrual workpapers, but its position is being challenged in a pending summons-enforcement case, United States v. Textron. The decision in that case promises to shed light on this important issue.

Conclusion

FIN 48 requires companies to perform a complete review of all material tax positions. Presumably, many of those positions will not involve difficult judgments as to whether tax benefits are allowable. However, some positions will require more analysis, and it is reasonable to expect that the company's auditors will be even more demanding than they have in the past. Where there is uncertainty about the proper tax treatment, it may be helpful to obtain a legal opinion.